Who Says Money Doesn't Grow on Trees?

By Maxxwell A.R. Chatsko - May 30, 2012 | Tickers: UFS, IP, RFP | 0 Comments

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It may never occur to you to invest in a paper company. There is probably a good chance you never looked at a paper product and wondered how it was made or where it came from. That’s because it is so seamlessly integrated into every aspect of everyday life, from paper towel rolls to parking tickets. That of course makes it a good candidate for a steady investment.

Let’s be honest, a paper mill isn’t the highest margin brick and mortar structure ever created. The paper industry has been hit hard in the last decade by declining profits, outdated mills, a shrinking workforce of paper engineers, and a lack of innovation. Most companies that are still around have focused heavily on R&D and continually evolving process designs, which is good news for the future of the industry. Two companies that deserve a closer look are Domtar Corp. (NYSE: UFS) and International Paper (NYSE: IP), both integrated pulp and paper companies with a wide array of fiber-based products.



The paper machines at Domtar's Johnsonburg, PA mill turn out 369,000 short tons of paper annually. That's a lot of parking tickets!


Many ways to grow

Domtar has a long way to go before it can really compete with industry stalwart IP, but the company is positioned for comfortable organic growth. Several years ago the company made it a priority to pay down debt. Net debt to total capitalization decreased from 35% in 2009 to 12% in 2011. That success paid off in 2011 as management returned $543 million (73%) of free cash flow to investors with its dividend and share repurchase program, which has been increased from $600 million to $1 billion this year. In fact, the company has increased dividends from $0.75 per share in 2010 (its first year with a dividend) to $1.80 per share in 2012. Domtar is a great growth play with a new and increasing dividend.

International Paper is a more mature paper products company that continues to grow through acquisitions -- the most strategic of which was a 75% stake in Andhra Pradesh Paper Mills, a leading Indian paper company, in 2011. IP gains access to two mills with a combined annual capacity of 250,000 metric tons of uncoated freesheet paper and completes its portfolio of BRIC nation assets. Global demand for uncoated freesheet is expected to grow at an annual pace of 1.6% for the next five years, especially in Southeast Asia and India. 

Another company trying to achieve growth in the low-margin paper industry is Resolute Forest Products Inc. (NYSE: RFP), formerly AbitibiBowater Inc. The company is still repositioning assets in an attempt to distance itself from a tumultuous 2007-2009, but if Domtar and IP offer any blueprint then such a transition is possible. RFP has an extensive network of 21 mills with an annual capacity of 2.1 million MT of commercial printing papers, 3.1 million MT of newsprint, and 1.1 million metric tons of market pulp. To many people’s surprise, newsprint is actually a cash-cow for the industry and accounted for 38% of 2011 sales. That’s 42% more than high-margin specialty papers!

Here’s a table comparing each company’s performance in 2011, which demonstrates that the focus on profitability is starting to pay off:

Declining demand? Focus on innovation

Domtar offers a roadmap for companies looking to innovate their way out of a slumping paper industry. North American demand for uncoated freesheet has declined at a 3.9% clip since 2000. That’s especially bad news for Domtar, which accounted for 35% of the North American market last year. In 2011 85% of the company’s revenue came from pulp and paper operations, compared to 14% for distribution and 1% from personal care (purchased in September 2011). Look for its distribution revenue to continue to replace pulp and paper revenue as the company sells more pulp outside of the North American market.

As a result, the company is making strides to diversify its revenue and has set a goal of achieving $300-$500 million of EBITDA generated from new business streams by 2016. The biggest bet on reaching that goal is the company’s CelluForce nanocrystalline cellulose (NCC) demonstration plant. NCC is a nanocomposite fiber material that has incredible strength and can also be used as a molecular building block for a multitude of applications, including printable solar arrays. It has been hailed as the greatest new raw material of the 21st century – albeit prematurely. Needless to say, NCC has the potential to be a tremendously profitable product for Domtar while diversifying away from traditional pulp and paper revenue streams.

Foolish bottom line

Widely expected to decline with the age of electronics and mobile devices, paper demand and production has actually doubled since the advent of the “paperless office.” It is a product that cannot be easily replaced, just easily forgotten. Its assimilation into everyday life makes it a great starting point for investment ideas and the innovative companies listed above may offer just that. They have reduced debt, created value for shareholders, and now eye developing markets and diverse revenue streams. The next time you hear the phrase “Money doesn’t grow on trees,” remember that for some of us, it really does.

Did you enjoy this article? Follow me on Twitter to keep up with my future posts on value opportunities, energy, and sustainable chemicals @BlacknGoldFool.

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